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June 11, 2012

It’s the ‘Warped’ Financial System, Stupid: Hussman

In a shareholder letter that reads like the economic equivalent of the viral “You Are Not Special” commencement address, portfolio manager John Hussman pins entrenched economic woes on a “warped” financial system that encourages speculation and refuses to restructure bad debt.

Hussman (left), the eponymous manager of Hussman Funds, derides the debate on the economy between conservatives and liberals—with the former seeking low taxes and decreased regulation and the latter seeking grander stimulus programs—as largely missing the real point, which he says is:

“The financial system has been transformed into a self-serving, grotesque casino that misallocates scarce savings, begs for and encourages speculative bubbles, refuses to restructure bad debt, and demands that the most reckless stewards of capital should be rewarded through bailouts that transfer bad debt from private balance sheets to the public balance sheet.”

The original sin in a lengthy chain of mistakes, according to Hussman, was the repeal of the Glass-Steagall Act, which allowed deposit institutions to engage in speculative trading, but with the effective backing of the U.S. government. A government backstop was also the central feature of the U.S. housing bubble, and when that bubble popped, both the Bush and Obama administrations failed to require bondholders to take losses on bad loans.

Hussman says the pattern of protecting speculators while socializing losses has been repeated internationally:

“When a country like Spain goes in to save a failing bank like Bankia—and does so by buying stock in the bank—the government is putting its citizens in a "first loss" position that protects the bondholders at public expense,” Hussman writes. This approach protects bank bondholders, but imposes eventual budget austerity on Spaniards, while having “no element of restructuring at all,” he adds.

Whether in the U.S. or abroad, Hussman says the reason the global economy has never recovered is that government policy encourages financial institutions to take risk but consumer demand is suppressed by existing debts, especially mortgages. (Hussman advocates a system in which banks reduce a debtor’s principal in return for participation rights in any future real estate appreciation.)

To restore the economy to growth, there is no substitute for “allowing bad investments to work out badly,” Hussman writes. Specifically, “the way to restructure a bank is to take it into receivership, write down the bad assets, wipe out the stockholders and much of the subordinated debt, and then recapitalize the remaining entity by selling it back into the private market. Depositors don't lose a dime.”

While protecting depositors, Hussman says government must remove protection from investment banking and trading activities.

“Unless we want a world where public services are cut to the bone in order to make bank bondholders whole, and where recession (or in some countries depression) is forced onto citizens in order to make government bondholders whole, the world's leaders will eventually have to wake up and recognize that bad debt requires bondholders who willingly took the risk to also take the loss,” Hussman writes.

That is not what is happening in Europe right now, where “a continent that is already excessively in debt is promising funds so that Spain can increase its government debt, and then needlessly protect the bondholders of Spanish banks, who should be subject to orderly restructuring instead,” he writes. Hussman adds that the only way Spain (“one of the four largest European nations, so it’s effectively being called on to lend to itself”) could make “a more explicit gift to bank bondholders would be to include wrapping paper and a bow.”

The Hussman Funds portfolio manager, who has long been predicting a recession in the U.S., says we are entering one right now, and reaffirms a “return/risk profile for stocks that is among the most negative 0.5% of historical instances.”

Hussman concludes: “The day-to-day ebb and flow of news will periodically create the perception that things are suddenly "fixed" thanks to some intervention, bailout, or agreement. Be skeptical—the headwinds here remain enormous.”